U.S. Corporate Profits Peaked?

Location Date:

June 1, 2011

Content:

I must admit that I am astounded at the performance of the U.S. equity market so far this year. Talk about climbing a wall of worries – I speak to a lot of money managers who are nervous as hell about public policy and the government interference in markets. I was reading a Jim Cramer post yesterday (yes, I am a fan and do subscribe to Real Money in full disclosure – he is entertaining, but also a very good market observer and he is all for the democratization of investment information which is terrific in my view) and he suggested that we are “not whistling past the graveyard,” but rather the market was going up because earnings and cash flow have been superb – top and bottom line. And you have no argument – on balance, they have been terrific.

Source: BCA Research, 2011
The question going forward though is, “are we at peak earnings and margins now for corporate America?”

The outlook for further corporate profit margin expansion seems highly unlikely to us.

Let’s first look at the cost side of the equation. Wages, which account for a large portion of firm costs, have been growing very weakly over the past few years.

Source: BCA Research, 2011

Beneath the surface a number of issues continue to brew. Firstly, there is a growing sense that “workers” are getting left behind as corporate profits continue to rise. While it is arguable that companies are increasing their workers’ wages in line with the growth in productivity, the disconnect comes when those wages are then placed against consumer prices for goods and services that have been rising much faster than the rate of productivity. Secondly, as a result, there is a wider gap in income inequality, especially since food and energy costs bite into such a large part of lower-income family budgets. I am not going to wade into the political consequences of this continuing, but issues like minimum wages, political backlashes, or greater union power (I am thinking about government employee unions) cannot be ignored. A record 44 million Americans are participating in the Food Stamp Program now.

On the productivity front, companies have not been re-investing in their capital stock

Source: BCA Research, 2011

While we may see a temporary boost in tech spending with the 100% year 1 write-off this year (1), it is hard to imagine that productivity growth rises substantially from here unless the labour force growth resumes its downturn later this year. The chart below suggests that a good deal of the strong corporate earnings rebrand came from cutting employees.

Source: Zero Hedge, 2011

Another component to consider is taxes. It is certainly a well-known fact that U.S. companies have had substantial international operations channeled through tax havens. Given the deteriorating U.S. fiscal situation and the general perception that U.S. corporates are not paying their fair share of taxes, this situation may not persist much farther into the future – or at least will not be allowed to grow in importance.

U.S. multi-nationals have also benefited from a big decline in the U.S. dollar (especially versus the euro since Europe represents over 55% of overseas net income for U.S. companies). It is very hard to imagine this continuing in perpetuity.

On the top line side, there is no doubt that GDP is highly correlated with corporate profits. We are definitely in a “soft patch” now for the global economy and this has now manifested itself with falling year-over-year profit growth in the non-financial sector (see the first graph above). The $64,000 question is how much of this slowdown is priced in and whether this slowdown has legs to it or not. Given that the consumer is 70% of GDP, with real wage growth anemic and deleveraging continuing on behalf of consumers, then perhaps this slowdown will have legs. Add to that the imminent cutbacks in government spending and the recently released “double-dip” in house prices, the concept of zero growth in Q3 is not out of the question. The situation in Europe will certainly not contribute to growth and neither will China’s efforts to curb inflationary pressures produce much in the way of growth for U.S. corporates. Unless we get QE3, it is hard to see how equities can advance from here unless the P/E rises. Add to this the fact that many strategists have been scrambling to increase S&P estimates for this year and the next and you have the recipe for a big disappointment and substantial correction.

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